On this post, I would like to send a message to the who has no financial and or accounting background (particularly; small business owner, who questions me (by email) often about financial accounting standards: There are fundamental limitations of financial accounting standards and income tax low you should realize, do not complicate your business with accounting work, accounting is a tool that you can utilize to maximize your business, not to minimize it.
Well, the real purpose of accounting systems is simple: Accounting systems are supposed to make succeeding in your business easier for you. You may think, therefore, that the world of accounting is a friendly place. Unfortunately, this scenario isn’t quite true. I’m sorry to report that two dark shadows hang over the world of accounting: financial accounting standards and income tax laws. (FYI: Even I am not a senior partner of the big four accounting firms, but as a controller, I know and toys with them quiet long).
The First Dark Shadow (Financial Accounting Standards)
“Financial accounting standards,” you say. “What the heck are those?” Here’s the quick-and-dirty explanation: Financial accounting standards are accounting rules created by certified public accountants. These rules are supposed to make reading financial statements and understanding what’s going on easier for people. (I happen to believe that just the opposite is often true, in case you’re interested). But because of what financial accounting standards purport to do, some people — such as bank loan officers — want to see profit and loss statements and balance sheets that follow the rules.
The exact catchphrase is one that you might have heard before: “prepared in accordance with generally accepted accounting principles”.
Unfortunately, the rules are very complicated; the rules are inconsistently interpreted; and actually applying the rules would soon run most small businesses into the ground. (And as you were running your business into the ground — you’ll be happy to know — your certified public accountant would make a great deal of money helping you figure out what you were supposed to be doing). So what should you do about this first dark shadow?
Glad you asked:
- First of all, know that it exists. Know that people like your banker honestly think that you should follow a super-complicated set of accounting rules.
- Also, don’t get sucked into the financial accounting standards tar pit.
- Tell people — your banker included — that you do your accounting in the way that you think enables you to best manage your business.
- Tell people; a small business like yours can’t afford to have an in-house staff of full-time CPAs.
- Finally, tell people that you don’t necessarily prepare your financial statements “in accordance with generally accepted accounting principles”.
Do attempt to fully and fairly disclose your financial affairs to people who need to know about them. Lying to a creditor or an investor about your financial affairs or getting sneaky with one of these people is a good way to end up in jail.
The Second Dark Shadow (Income Tax Laws)
And now here’s the second dark shadow: income tax accounting laws. You know that any parliaments in the world, enacts tax legislation to raise revenue. And you know that it does so in a political environment strewn with all sorts of partisan voodoo economics and social overtones. So you won’t be surprised to find out that the accounting rules that come out of the nation’s capital and your state capital don’t make much sense for running a business.
You need to apply the rules when you prepare your “tax return“, of course, but you don’t have to use them the rest of the year. A far better approach is to do your accounting in a way that enables you to best run your business. That way, you don’t use accounting tricks and gambits that make sense for income tax accounting but foul up your accounting system. At the end of the year, when you’re preparing your tax return, have your tax preparer adjust your trial balance so that it conforms to income tax accounting laws.
The Danger of Shell Games
This post is longer than I initially intended. I’m sorry about that. I want to share one more thought with you, however. And I think that it’s an important thought, so please stay with me just a little longer.
You could use the accounting knowledge that this post imparts to do the bookkeeping for a very large business. As crazy as it sounds, if you had 5,000 cars for rent — perhaps you have rental outlets at dozens of cities scattered all over the world — you might actually be able to keep the books for a $200 million-a-year business. You would have to enter many more transactions, and the numbers would all be bigger, but you wouldn’t necessarily be doing anything more complicated than how the transaction should be.
Unfortunately, the temptation is great — especially on the part of financial advisors — to let the money stuff get more complicated as a business grows. People start talking about sophisticated leasing arrangements that make sense because of the tax laws. Some customer or vendor suggests some complicated profit-sharing or cost-reimbursement agreement. Then your attorney talks you into setting up a couple of new subsidiaries for legal reasons.
All these schemes make accounting for your business terribly complicated. If you choose to ignore this complexity and go on your merry way, very soon you won’t know whether you’re making money. (I’ve seen plenty of people go this route — and it isn’t pretty). On the other hand, if you truly want to do accurate accounting in a complex environment, you need to spend a great deal of cash for really smart accountants. (This tactic, of course, assumes that you can find, hire, and afford these really smart accountants). If you’re unsure how to tell whether something is just too complicated, here’s a general rule you can use: If you can’t easily create the journal entries that quantify the financial essence of some event, you’re in trouble.
So what should you do? I suggest that you don’t complicate your business’s finances — not even if you think that the newfangled, tax-incentivized, sale lease back profit plan is a sure winner. Keep things simple. To win the game, you have to keep score, right?